Betting on Growth Stocks

Value-oriented funds have taken the lead in recent months, but many pros now see brighter prospects for funds that invest in fast-expanding businesses

By ANNELENA LOBB

Seemingly cheap "value" stocks and the mutual funds that buy them have led the stock market up from March lows.

But many professional investors believe that market leadership is poised to shift to "growth" stocks, those of companies with greater potential to expand earnings and revenue.

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Distinctions in relative performance seemed pointless during the bear market, when shares of every type of company—small, large, growth, value—got crushed. In the rebound from the March 9 low, clearer patterns have emerged.

Small stocks have beaten large stocks, and among companies of all sizes, value stocks have beaten growth. For instance, funds holding small value stocks are up 74% (through Oct. 28), compared with a 58% increase for funds holding small growth stocks, according to Morningstar Inc. Funds holding large growth stocks are up 52%, the smallest advance among nine categories of diversified U.S. stock funds.

It is common for value companies, whose shares appear cheap compared with their earnings, revenue or book value, to lead the way out of a trough. During a severe economic downturn, share prices for the smallest, most struggling firms can collapse because investors sell shares of companies they fear will go bankrupt. "Many cheap value companies are cheap because people doubt their sustainability," says Ron Sloan, a senior portfolio manager at Invesco Ltd.'s AIM fund unit. When the economy starts to improve and it becomes clear that those firms won't go under, they can rebound sharply.

But many investors say that effect won't last. Small, risky value companies are unlikely to keep leading if a U.S. economic recovery remains weak. Without robust domestic demand, such companies may not perform well and will probably cede leadership to growth companies perceived to have the ability to thrive even in a lackluster economy. Technology, the classic growth sector, could benefit as companies try to maximize productivity in a "jobless" recovery.

Robert Neubecker

"If we're in a tough world where revenues are hard to come by, where you need to sell to emerging markets to find growth, bigger companies will benefit more, and old-fashioned growth businesses" will begin to outperform the value companies that have led the bounce, says Mr. Sloan. Tech giants such as Intel Corp., Cisco Systems Inc. and Motorola Inc., which earn a large portion of their revenues overseas, along with health-care firms like Medtronic Inc., could be winners, he says. All are holdings in the AIM Charter fund for which he is lead manager.

Trading Leads

Near a recession trough, value stocks usually start outperforming growth stocks, says Dave Hintz, head of U.S. equity research at Russell Investments. "Sometimes it is slightly before the trough, [or] slightly after," he says.

Over longer periods of time, growth and value stocks tend to switch off in terms of stock-market leadership. That's seen, for example, in the performance of the growth and value components of the Russell 3000 index of large and small stocks.

The Russell 3000 Growth Index has generally led the Russell 3000 Value Index since August 2006 on a two-year rolling basis—that is, comparing their performance over multiple overlapping 24-month periods.

From March 2000 to August 2006, value beat growth, except for a couple of short periods, according to data from Russell. And during the tech bubble of the late 1990s, growth led, which isn't surprising, given that the technology sector makes up a big portion of growth indexes.

From March 9 to Oct. 28, the Russell 3000 Value Index rose 63%, while the Russell 3000 Growth Index gained 54%. But year-to-date, the growth index was up 26%, beating the value index's 12% gain.

Eventually, there will be "a handoff" from value back to growth, says Chris Guinther, chief investment officer and president of Silvant Capital Management LLC in Atlanta. Silvant sub-advises three growth-focused mutual funds for RidgeWorth Funds. Silvant predicts growth will outperform value in the next two calendar years.

Growth also looks cheaper than usual relative to value, says Russell's Mr. Hintz. The large-stock Russell 1000 Value Index had a price/sales ratio of 1.00 at the end of September, the most recent figure available, compared with 1.55 for the growth index. A growth premium of 55% is low, he says; at other points, it has been more than 100%.

The industry compositions of growth and value indexes are very different, with financials typically dominating the value indexes and technology stocks accounting for a big portion of the growth indexes. Tech and health-care shares each account for about a quarter of the small-stock Russell 2000 Growth Index, for example, while financials make up about a third of the small-stock Russell 2000 Value Index.

Interestingly, the financial sector hasn't driven the performance of the small-cap value index since March, says Jeff Cardon, chief executive officer of fund manager Wasatch Advisors Inc. in Salt Lake City and manager of Wasatch Small Cap Growth. As of early last week, financials had gained about 55%, while the whole index was up about 75%. The best-performing sectors, according to data from Russell, have been consumer-discretionary and energy stocks.

In contrast to larger financial stocks, which have had a huge rebound off March's "panic levels," smaller financials, such as community banks and little banks with real-estate exposure, are still struggling, says Charlie Smith, chief investment officer at Fort Pitt Capital Group Inc. and portfolio manager of Fort Pitt Capital Total Return, which takes a value-based approach.

If the financial system continues to show signs that it is healing, he expects the value category to continue to lead growth. But "the small banks would [need to] pick it up," he says. If their recovery is sluggish, then growth will probably outperform value, he says.

Tech's Story

Many fund managers like the technology sector now, including Wasatch's Mr. Cardon. If business must "do more with less" in a jobless recovery, he says, "one way to do that is with technology." He likes Riverbed Technology Inc., which makes network-optimization products, and Power IntegrationsInc., which makes semiconductor products that lower the energy consumption of certain consumer goods.

Charlie Mercer, manager of Aston/Veredus Select Growth, says he has been buying shares of companies such as Micron Technology Inc., SanDisk Corp. and Intel since the beginning of this year. Mr. Mercer expects business spending on personal computers and servers to rise in the coming years after a long period of reduced investment.

And Allison Thacker, a co-portfolio manager of several funds at RS Investments, likes computer-security company McAfee Inc. "When you survey IT managers about their priorities and what to spend on in this environment, they say you can't cut security and you can't cut storage," she says.

— Ms. Lobb is a writer based in New York. She can be reached at reports@wsj.com